Regulatory scrutiny by the Securities and Exchange Commission and the brutal dogfight for scarce alpha are pushing US hedge funds to implement a more rigorous and formalised trading process, according to a study from TABB Group.

The firm’s eighth annual benchmark study – US Hedge Fund Equity Trading 2013: Better Practices for the Age of Transparency – says that hedge funds are working with their sell side counterparts to bring additional cost-efficiency to an industry that is seeing revenues fall for the fourth straight year. The industry needs head traders to continually act as evangelisers for better practices.

According to TABB, each decision in the trading process must be empirically defensible and contribute positive value to alpha capture. Where possible, an electronic trail of decisions made by portfolio managers and buy-side traders as well as the surrounding communication should be captured and analysed, everything from the broker vote and the timing of trades, to the use of dark pools and commission-sharing agreements (CSAs).

“The US regulatory climate is harsher today than at any time in the past for US hedge funds and now that a majority of funds are registered with the SEC as investment advisers, regular examinations will be standard operating procedure,” says Adam Sussman, a TABB partner and director of research who co-authored the study with research analyst Colby Jenkins.

The new study is based on interviews with head traders between January and April 2013 at 63 US-based hedge funds trading equities with aggregate global assets under management (AuM) of USD301bn. Although these in-depth conversations focused on US equity trading, 76 per cent of the firms traded products in other asset classes or participated in trading outside of the US.

The study includes a comparison of the practices between US hedge fund trading desks and traditional asset managers, pointing out areas that each could improve upon.

Topics throughout the report include: top regulatory concerns; the use of commission-sharing agreements (CSAs); commission rates for sales trading, program trading, algorithms and dark pools; presence of algorithm providers; and best-in-class high touch service and best-in-class algorithm providers.

A sampling of the study’s top 10 findings includes:

· A more dramatic than usual shift in presence is seen among the top five overall and top five algorithm brokers in 2012, driven by changes in the sell-side trading landscape and an increased focus on broker relationships over execution performance.
· Hedge fund traders have become more receptive to integration of brokerage services since 2012.
· The lack of differentiation among broker algorithms does not mean there is no differentiation among the overall service.
· Two-thirds of the firms have already established a formal broker-vote process; among these funds, 70 per cent conduct the voting process on a quarterly basis, at a minimum.

“Regulatory change notwithstanding, beyond the trading desk, the role of the hedge fund trader continues to be dynamic,” says Sussman. “There is increased pressure to formalise trading and brokerage relationship practices in response to investor demands, regulatory oversight and a mature organisational management layer. Although the core processes are not changing, business conduct is becoming more rigorous.”

He adds that despite these pressures, a significant portion of the market is playing catch up.